Subscription models are good investments

During such periods, we look to assess the quality of business models and how these might evolve. From our analysis, we anticipate the continuation in growth of the subscription model as it benefits companies in both good and bad times.

As more companies look to address the acceleration in remote working, there are also important considerations around the ever-changing technology landscape, proliferation of data and the evolving workforce demographic.

Key Points

• Covid-19 is forcing companies to rethink their business model.
• Those models that are based on subscriptions are more resilient.
• Subscription models offer defensiveness and earnings quality.

This requires businesses to be more agile and adaptable to client demands, in some instances resulting in a sizeable shift in business strategy.

The move to a model where customers pay a subscription fee for usage is becoming increasingly prevalent across multiple industries. Whileit has not always found success, its financial benefits are becoming more prominent.

Streaming apps such as Spotify and Netflix have operated this model for some time. 

Disney has more recently been successful on its direct-to-consumer launch. 

Video game developers Electronic Arts and Ubisoft have achieved further monetisation of back catalogue content through monthly subscription service.

Meal-kit services like Pasta Evangelist and HelloFresh have also boomed in recent months.

Meanwhile, subscription within food manufacturing and consumer goods is still a niche market and has seen mixed fortunes.

Nestlé and Procter & Gamble have looked to become a greater participants, though it is questionable whether it has previously yielded material benefit for Mondelez or Unilever.

Why is this model becoming increasingly important?

For companies, there is the principal idea of greater visibility on growth and cash flow from a recurring revenue stream. This works best for products that have low churn as it offers a better way to monetise content or a service.

Importantly, it provides higher total lifetime value. 

From the customer viewpoint, there is the benefit of greater accessibility, flexibility, simplicity in pricing and value. Think of Spotify versus buying CDs. For the average person, you will likely find they probably have paid more over 10 years.

However, the wealth of choice and access is unparalleled as it offers a tremendous amount more for your money.

Aveva believes the move to subscription improves the quality of earnings and drives a more sustainable future

Turning our singular attention to UK tech, there are two examples within the software industry where penetration of this model is on the rise.

Industrial software provider Aveva is driving the digitalisation transformation of process industries.

Two years ago the group completed its merger with the industrial software business of Schneider Electric, with the combined group now a market-leading visualisation software, real-time data and analytics company.

At the time, it announced a series of medium-term targets to improve the operational performance of the business. If we fast forward to the recently announced full year results, we can see that the business model transition is progressing ahead of plan.

Recurring revenues were up 25.7 per cent, which helped increased the subscription element of the business to 62 per cent of total revenue.

New products like Aveva Flex, within its monitoring and control division, has found early success, including contract wins with two blue-chip North American food and beverage companies.

Aveva believes the move to subscription improves the quality of earnings and drives a more sustainable future. It helps them trial and utilise new products, improve greater lifetime value and allows for further innovation investment.

Crucially, securing these multi-year deals has a positive impact on both revenues and free cash flow. For a customer, it represents an opportunity to flex usage and offers a low risk way of trying new products that pay for themselves in efficiency savings.

Further, it allows for flexibility in challenging economic times, where they can use tokens on what they need, as opposed to having committed to specific products on mass volume.

Value-add business models prove attractive

Accountancy software business Sage Group continues to press on its with its pursuit of becoming a leading software-as-a-service company.

Sage targets the professional user in small and medium-sized businesses, so it needs to be flexible at all times given the customer base. Recurring revenues take several forms, most notably support and product bundling within subscription contracts.

This represents a key attraction of the Sage business model, in our view. Subscription revenues have more than doubled as a percentage of group revenues over the past few years, with Sage Business Cloud subscription revenues now twice the size of on-premise subscriptions.

Combined with cloud technology, this allows Sage to offer more value from product investment, which boosts retention rates of existing customers and is crucial for new customer acquisition.

Outside of software, specialist retail is another industry where subscription models are being adopted in the move towards digital. One example that is exposed to a fast growth category is Pets at Home.

As part of its multi-channel strategy, management considers subscription to be a value creator and enabler in their bid to cover the total pet care ecosystem.

This brings additional incremental opportunities from online customisation, in addition to the potential for 100 per cent lifetime order capture for each household pet.

In doing so, it can also be utilised to drive footfall traffic in stores through cross-sell and other offers.

This versatile business model offers significant economic value, in our view. It brings scale and agility, delivers a steady stream of income and helps manage operating costs.

We expect to see a continuation of attractive growth rates from subscription services, as it offers both defensiveness and earnings quality to a business, particularly during times of economic turbulence.

Gavin Launder is a senior portfolio manager, active equities, at LGIM